Let Gunns convertibles be a warning

The collapse of Tasmanian timber group
Gunns
in the week has focused attention on the growing risks inherent in the complex area of so-called hybrid securities.

Late last month Gunns gave investors notice that its $100 Forests convertible notes, which were last quoted at $45, would be converted into shares, officially as of October 15.

The move has been criticised by advisers as a cynical use of the complex rules surrounding these investments at a time when the company was under stress and its shares suspended.

The Gunns collapse, after which investors are likely to see a nil return, came at a time of increased scrutiny of the expanding range of listed income investments, commonly described as hybrids, and prompted warnings from some advisers and regulators that many investors – especially mum and dad do-it-yourself super fund investors – don’t fully understand the risks they are taking.

Not being fully aware of these risks, which have recently been highlighted by new issuers and changes to the rules, could result in unsophisticated investors owning securities that are totally unsuitable for their purposes.

While some of these investments are offering some of the best yields in the current environment, says Tom Murphy, managing partner of investment adviser Family Office Research and Management, it’s a worry that so many investors view them in the same light as fixed-income bonds.

Although they share some characteristics, such as paying regular income and returning capital at the end of an investment period, listed income securities can backfire in spectacular fashion if things don’t work out.

They are a specialised family that includes hybrid securities, floating rate notes, convertible notes, convertible preference shares and corporate bonds.

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While they can be bought and sold through the stockmarket, they are mostly added to a portfolio as a result of offers from banks and major companies via stockbrokers and financial advisers and direct offers to investors who own shares in the offering companies. So they are generally held as long-term investments with rollover options.

This is why certain advisers and regulators, including the Australian Securities and Investments Commission, are warning that the current crop of offerings is being launched with features that make them significantly different and potentially riskier than previous ones. These changes are seeing a revised style of hybrid being offered and current examples are
Commonwealth Bank
’s Perls VI series and convertible preference share issues by
Bendigo and Adelaide Bank
and
Suncorp
.

These investments have introduced trigger events in their structures such that they automatically convert into shares if the issuing bank experiences a crisis and their share price falls dramatically.

Preference shares are the most common type of hybrid issued by banks and companies, and normally pay a floating rate of interest over the bank bill swap rate with a redemption date after a defined period such as five years.

If the securities aren’t redeemed at the end of the term, then the income coupons “step up" to a higher interest rate to compensate investors for non-redemption. While the standard procedure then sees them become perpetual in nature – in other words they keep paying interest at the higher stepped-up rate – the new rules require the investment to be converted into shares, especially if the bank has financial problems.

If the Commonwealth Bank Perls VI hybrids, for instance, are not redeemed by the bank by the end of 2018, the new rules – which have the approval of regulators such as the Australian Prudential Regulation Authority – state they must be converted into shares, as long as the price is above $30.

The downside of this new requirement, says Murphy, is investors need to be aware that if things don’t go well, the new rules will trigger a conversion into shares at a time of maximum pain – while prices are down dramatically.

Although Commonwealth Bank shares have lately been trading in the mid-$50s, it’s worth noting that they traded as low as $24 during the major sharemarket collapse in March 2009.

Also, although banks look to be reasonable investments at present, there have been periods when some have got into serious trouble, such as Western Australia’s Bankwest in 2008 and Westpac in 1991.

Demonstrating just how painful a compulsory conversion can be, says Murphy, is the demise of the Tasmanian forestry group Gunns and its recent conversion decision, which was due to take place on October 15.

The board planned to use this conversion to reduce its overall debt load by $120 million.

While the conversion into 421.7 shares for every note was in line with the conversion formula set down for these investments, the fact that they will almost certainly become worthless shares will be extremely disappointing to investors, who may have hoped for some capital back.